This got me thinking a little bit and to be honest I would be lying if I said the current "property investors are cheating the system" attitude didn't annoy me. The ability to claim depreciation on a property investment is normal international practice and was never a loop hole or a tax cheat. However, making an investment choice based purely on tax reduction is not good practice. I invest to make money; if I can save tax along the way it is only a bonus. In any case, as many people are about to learn, you do not base decisions to invest or not to invest on tax rules only, because tax rules can change.
Why Property Still Wins
Lets assume we have $20 000 to invest. For the sake of the exercise we will narrow our options to a managed fund or a small rental property.
Option 1. A good managed fund.
I take my $20 000 and invest it in an agressive investment fund buying a diversified pool of stocks and bonds etc. This week I sit down with a financial adviser and he explains to me that in such a fund I would likely generate a return of 7% p.a. over the long term.
Return on investment:
Start $20 000.00
Year 1 $21 400.00
Year 2 $22 898.00
Year 3 $24 500.86
So, after 3 years with a 7% annual return I would have made $4 500.00 on my original $20 000; not bad.
Option 2. A rental property.
In this option I will use my $20 000 as a deposit on a rental property. The property will cost $100 000, and for the sake of our exercise will also experience capital gain at a rate of 7% (Value doubling every 10 years). We will assume the property is neutrally geared and the rent pays all of the costs (mortgage, repairs, insurance, etc.)
So at day one I pay down a 20% deposit on a $100 000 property.
Year Property Value Equity
Start $100 000 $20 000
Year 1 $107 000 $27 000
Year 2 $114 490 $34 490
Year 3 $122 504 $42 504
So in this scenario I will have made $22 504.00 on my original $20 000 investment, more than doubling my money in 3 years.
Why The Unfair Advantage
As you can see, even without any tax advantages, property beats a typical investment package even with the same rate of return (incidentally, in this scenario the rental property will out perform the fund even if capital gain is only added at a rate of 2% per annum, returning $6 120 in three years). The reason for this is simple: Leverage.
With a house or a piece of land it is possible to borrow 80% sometimes more of the value and it then becomes possible to make money on borrowed money. This is called leverage, for every $1.00 we invest, it is possible to use $5.00 of someone else's money and in this way it is possible to get ahead much faster.
What's The Risk?
With any investment there is a degree of risk. The hard facts are that a rental property could lose value, a tenant could do damage, or interest rates could go up. The same applies to a managed fund, the market could collapse, there could be a recession, or there could even be a war! There are a million things in any venture in life that could go wrong; the key is to get good advice, good insurance, and make careful, intelligent decisions.
One thing I will say about the risk comparison is that banks depend on risk managment for their very survival. If they lend you or me money, they take a risk and they must decide if we are a good risk, and decide if where we intend to spend the money is a good risk.
That said, how likely is a bank to lend you money to buy stocks? Not very likely and certainly not 80-90% of the value. Isn't it interesting that banks are generally quite happy to lend hundreds of thousands of dollars to buy property? Perhaps they know something the share brokers and fund managers don't?
Perhaps property is still one of the safest and most profitable investments in the world today, even if the tax laws are changing!
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